Wednesday, June 22, 2011

Why Investing in the Stock Market for Less Than 5 Years is Risky

This post provides justification for the adage that you should not put money into the stock market that you will need in less than 5 years. It is the 5-year version of earlier posts that discussed the distribution of 10 and 20-year stock market returns (see links below).

Some years back, a friend asked me to recommend a good stock investment for her daughter's college fund. Since withdrawals were to start in about three years, my recommendation was not to put the college fund in the stock market at all! Here's why.

What will a $20,000 Stock Market Investment be Worth in 5 Years?

In previous posts, we have looked at the distribution of historical outcomes for typical (but hypothetical) investors investing in the stock market for 10 years and for 20 Years. For those holding periods, the investors virtually always made money -- though sometimes barely so. In approximately 100 sample 10-year periods since 1900, we saw only one instance where the investor's ending portfolio was worth less than his initial investment -- and no instances for 20-year periods.

The above graph (click to expand) is the 5-year version of the earlier charts. It shows the historical results of investing $20,000 in the stock market for 5 years. The horizontal axis shows values of the portfolio at the end of the 5 years assuming dividends were reinvested (and, no taxes). The lines and bars reflect the frequency of various outcomes for about 100 5-year periods beginning year-end 1899.

(Note: to calculate ending portfolio values for an initial investment of $1,000, divide the ending portfolio values by 20. To calculate the results for n thousand dollars, multiply the results for $1,000 by n. For example, for a $50,000 investment, multiply the results for $1,000 by 50.)

Short-Term Investments in the Stock Market are Risky

Long-term stock market returns have averaged about 10%/year (see Average Stock Market Returns since 19xx). However, yearly returns vary dramatically (see Stock Market Yearly Returns). Over time, the long-term average prevails. However, the shorter the investment period, the more the investor is at the mercy of the yearly variation, and the less he takes advantage of the longer-term trend. As a result, short-term investments are significantly more risky than 10 and 20-year investments.

Worst-Case Stock Market Returns for Short-Term Investments

The blue bars show the number of years, indicated on the left vertical axis, where the ending portfolio was less than or equal to the amount shown on the horizontal axis. For example, there were two years where the ending portfolio was less than $10,000, and 22 years where the ending portfolio was less than $25,000.

In our earlier analysis, the worst 10-year result was a loss of a little over 10%. The worst 20-year result was a gain of over 50%. The worst 5-year result is close to a 60% loss -- a $20,000 initial investment resulted in an ending portfolio of a little over $8,000. By this measure, four-year results were even worse. The worst 4-year result was an ending portfolio of a bit over $5,000 -- a loss of more than 70%! Results like those could be a major problem for a high school student's college fund....

Frequency of Stock Market Losses for Short-Term Investments

Life is full of risks. Many readers might find the risk of even a 70% loss tolerable if the chances of realizing that loss were sufficiently remote. For example, most people think that the risk of their plane crashing is remote enough for them to continue to fly.

The green line shows the cumulative probability, measured against the right vertical axis, that the investor's ending portfolio value will be less than the value on the horizontal axis. For example, investors lost more than half of their $20,000 investment (i.e., ended with less than $10,000) about 2% of the time -- that's the meaning of the "2%" above "$10,000" on the horizontal axis. Similarly, the green line shows that our hypothetical investors' ending portfolio was worth less than the $20,000 they initially invested about 7% of the time.

How Often Will I Lose Money Investing in the Stock Market for One Year?

The risk of losing money tends to increase as the number of years decreases. Whereas hypothetical investors lost money 7% of the time over five years, investors investing for four years lost money 12% of the time; one-year investors lost money 27% of the time (see graph above). Note, however, that the worst-case loss was "only" a little less than 50% -- less than the two, three, four and five-year worst cases.

Implications of Stock Market Variability on Retirement Planning & Buying a House

These results have implications not only for planning for college. They are relevant to planning for any known, "fixed" obligation. For example, if you need money for a down payment on a home in the next few years, having that money invested in the stock market is clearly risky.

Similarly, you might want to protect retirement savings needed for near-term expenses from short-term variations in the stock market. As a retiree, my personal rule of thumb is to keep cash needed for the next five years protected from stock market variations. However, putting that money in the stock market can make sense if you are comfortable with the risks -- especially if even worst-case results have little impact upon your lifestyle.

Note: As always, these results are for hypothetical investors investing in the DJIA (Dow Jones Industrial Average); results do not include the impact of loads/commissions, transaction fees, taxes or other expenses. Dividends are reinvested annually. Investments in any broad stock market average, such as the S&P 500, would show similar theoretical results.